The Interplay Between Student Loans and Credit Card Debt ...

[Pages:65]Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs

Federal Reserve Board, Washington, D.C.

The Interplay Between Student Loans and Credit Card Debt: Implications for Default in the Great Recession

Felicia Ionescu and Marius Ionescu

2014-14

NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers.

The Interplay Between Student Loans and Credit Card Debt: Implications for Default in the Great Recession

Felicia Ionescu Federal Reserve Board

Marius Ionescu Colgate University

February 3, 2014

Abstract

We theoretically and quantitatively analyze the interactions between two different forms of unsecured credit and their implications for default behavior of young U.S. households. One type of credit mimics credit cards in the United States and the default option resembles a bankruptcy filing under Chapter 7; the other type of credit mimics student loans in the United States and the default option resembles Chapter 13 of the U.S. Bankruptcy Code. In the credit card market a financial intermediary offers a menu of interest rates based on individual default risk, which account for borrowing and repayment behavior in both markets. In the student loan market, the government sets the interest rate and chooses a wage garnishment to pay for the cost associated with default.

We prove the existence of a steady-state equilibrium and characterize the circumstances under which a household defaults on each of these loans. We demonstrate that the institutional differences between the two markets make borrowers prefer to default on student loans rather than on credit card debt. Our quantitative analysis shows that the increase in student loan debt together with the expansion of the credit card market fully explains the increase in the default rate for student loans in recent normal years (2004-2007). Worse labor outcomes for young borrowers during the Great Recession (2008-2009) significantly amplified student loan default, whereas credit card market contraction during this period helped reduce this effect. At the same time, the accumulation of student loan debt did not affect much the default risk in the credit card market during normal times, but significantly increased it during the Great Recession. An income contingent repayment plan for student loans completely eliminates the default risk in the credit card market and induces important redistribution effects. This policy is beneficial (in a welfare improving sense) during the Great Recession but not during normal times. JEL Codes: D11; D91; G33; H81; I28;

Keywords: Default, Bankruptcy, Student Loans, Credit Cards, Great Recession

The views expressed herein are those of the authors and do not necessarily reflect those of the Federal Reserve Board or its staff. The authors thank Simona Hannon, Juan-Carlos Hatchondo, Wenli Li, Leo Martinez, Makoto Nakajima, Michael Palumbo, Pierre-Daniel Sarte, Nicole Simpson, and Rob Valletta for comments and participants at the Society for Economic Dynamics, Midwest Macroeconomics Meeting, Society of Advancements in Economic Theory, the NASM, the NBER, Household Finance group, and seminar participants at Bank of Canada, Colgate University, FRB of Richmond, Federal Reserve Board, University of Alberta. Special thanks to Kartik Athreya, Satyajit Chatterjee, Dirk Krueger, and Victor Rios-Rull for helpful suggestions and to Gage Love for excellent research assistance. Emails: felicia.ionescu@; mionescu@colgate.edu.

1 Introduction

Student loan debt has steadily increased in the last two decades, reaching 1.2 trillion dollars in 2012. In June 2010, total student loan debt surpassed total credit card debt for the first time (see Figure 1 in Section 2). Currently, 70 percent of individuals who enroll in college take out student loans; the graduates of 2013 are the most indebted in history, with an average debt load of $27,300 (College Board (2013)). At the same time, the two-year basis cohort default rate (CDR) for Federal student loans steadily declined from 22.4 percent in 1990 to 4.6 percent in 2005 and has increased ever since, reaching record highs in the last decade (at 10 percent for FY2011).1

The accumulation of student loan debt alone cannot explain the recent increase in student loan default rates of young U.S. households. A second market is needed to understand this behavior: the majority of individuals with student loan debt (66 percent in 2004-2007) also have credit card debt, according to our findings from the Survey of Consumer Finances (SCF). Credit card usage is common among college students, with approximately 84 percent of the student population having at least one credit card in 2008 (Sallie Mae (2009)). While both of these loans represent important components of young households' portfolios in the United States, the financial arrangements in the two markets are very different, in particular with respect to the roles played by bankruptcy arrangements and default pricing. Furthermore, credit terms on credit card accounts have worsened in recent years, adversely affecting households' capability to diversify risk but also limiting the young borrowers' indebtedness.

We propose a theory about the interactions between student loans and credit card loans in the United States and their impact on default incentives of young U.S. households. As we argue in this paper, this interaction between different bankruptcy arrangements induces significant trade-offs in default incentives in the two markets. Understanding these trade-offs is particularly important in the light of recent trends in borrowing and default behavior. Data show that young U.S. households (of which a large percentage have both college and credit card debt) now have the second highest rate of bankruptcy (just after those aged 35 to 44). Furthermore, the bankruptcy rate among 25to 34-year-olds increased between 1991 and 2001, indicating that this generation is more likely to file for bankruptcy as young adults than were young boomers at the same age.2 Moreover, student loans have a higher default rate than credit card loans or any other type of loan, including car loans and home loans.3

1The 2-year CDR is computed as the percentage of borrowers who enter repayment in a fiscal year and default by the end of the next fiscal year. Trends in the 2-year CDR are presented in Figure 2 in the Appendix.

2Source: . 3According to a survey conducted by the FRB New York, the national student loan delinquency rate 60+ days in 2010 is 10.4 percent compared to only 5.6 percent for the mortgage delinquency rate 90+ days, 1.9 percent for bank card delinquency rate and 1.3 percent for auto loans delinquency rate. Based on an analysis of the Presidents FY2011 budget, in FY2009 the total defaulted loans outstanding are around $45 billion.

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These trends are concerning, considering the large risks that young borrowers face: first, the college dropout rate has increased significantly in the past decade (from 38 percent to 50 percent for the cohorts that enrolled in college in 1995 and 2003, respectively).4 Furthermore, the unemployment rate among young workers with a college education has jumped up significantly during the Great Recession: 8 percent of young college graduates and 14.1 percent of young workers with some college education were unemployed in 2010 (Bureau of Labor Statistics). In addition, in order to begin repaying their student loan debt, many college graduates resort to underemployment outside their fields of study, especially after the Great Recession, a move that may have long-term deleterious financial effects.5

The combination of high indebtedness and high income risk in the Great Recession implies that borrowers are more likely to default on at least one of their loans. A few questions arise immediately: First, which default option do young borrowers find more attractive and why? In particular, is the current environment conducive to higher default incentives in the student loan market? Second, absent the Great Recession, how much of the increase in default on student loans is explained by trends in the student loan market and how much by trends in the credit card market? Lastly, how much does the Great Recession amplify default incentives?

In order to address the proposed issues, we develop a general equilibrium economy that mimics features of student and credit card loans. Infinitely lived agents differ in student loan debt and income levels. Agents face uncertainty in income and may save/borrow and, as in practice, borrowing terms are individual specific. Central to the model is the decision of young college-educated individuals to repay or default on their credit card and student loans. Consequences of defaulting on student and credit card loans differ in several important ways: for student loans, they include a wage garnishment, while for credit card loans, they induce exclusion from borrowing for several periods. More importantly, credit card loans can be discharged in bankruptcy (under Chapter 7), whereas student loans cannot be discharged (borrowers need to reorganize and repay under Chapter 13). Borrowing and default behavior in both markets determine the individual default risk. This risk, in turn, determines the loan terms agents face on their credit card accounts, including loan prices. In contrast, the interest rate in the student loan market does not account for the risk that some borrowers may default.

In the theoretical part of the paper, we first characterize the default behavior and show how it varies with households' characteristics and behavior in both markets. Then we demonstrate the existence of cross-market effects and their implications for default behavior. This represents the main contribution of our paper, a contribution which is two-fold:

4We define the dropout rate as the fraction of students who enroll in college and do not obtain a bachelor degree 6 years after they enroll. Numbers are based on the BPS 1995 and 2003 data.

5Research argues that young college-educated individuals graduating during the Great Recession earn 15 to 20 percent less on average relative to those who graduated before the Great Recession Kahn (2010).

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1) Our theory delivers the result that in equilibrium, credit card loan prices depend not only on the size of the credit card loan (as in Chatterjee, Corbae, Nakajima, and Rios-Rull (2007)), but also on the size of the loan and the default status in the student loan market. This is a direct consequence of the result that the probability of default on any credit card loan decreases with the amount of debt owed in the student loan market. Also, this default probability is higher for an individual with a default flag in the student loan market relative to an individual without a default flag. To our knowledge, these results are new in the literature and provide a rationale for pricing credit card loans based on behavior in all credit markets in which individuals participate.

2) In any steady-state equilibrium, we find a combination of student loan and credit card debt for which the agent defaults on at least one type of her loans. Moreover, we find that for larger levels of student loans or credit card debt than the levels in this combination, default occurs for student loans. This result is novel because it shows that while a high student loan debt is necessary to induce default on student loans, this effect is amplified by indebtedness in the credit card market. This arises from the differences in bankruptcy arrangements in the two markets: the financially constrained borrower finds it optimal to default on student loans (even though she cannot discharge her debt) in order to be able to access the credit card market. Since defaulting on student loans causes a limited effect on her credit card market participation (shortly-lived exclusion and higher costs of loans in the credit card market), this borrower prefers the default penalty in the student loan market over defaulting in the credit card market, an action which would trigger long-term exclusion from the credit card market.

In the quantitative part of our paper, we parametrize the model to match statistics regarding student loan debt, credit card debt, and income of young borrowers with student loans (as delivered by the SCF 2004-2007). There are several sets of results.

First, our findings reveal large gaps in credit card rates across individuals with different levels of student loan debt and default status in the student loan market. This result strengthens our theory and emphasizes the quantitative importance of correctly pricing credit card debt based on behavior in other credit markets.

Second, we find that individuals with no credit card debt have lower default rates on student loans than individuals with credit card debt. Furthermore, individuals with low levels of credit card debt and low levels of student loan debt do not default on credit card debt, but they do default on their student loans. For them, the benefit of discharging their credit card debt is small compared to the large cost associated with default (exclusion from borrowing). Individuals with large levels of credit card and student loan debt are more likely to default on student loans.

Third, we determine combinations of levels of student loans and credit card debt above which borrowers are more likely to default, a result which complements our main theoretical result. Our findings suggest that having debt in the credit card market amplifies the incentive to default on

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student loans. Fourth, an interesting result is that conditional on participating in the credit card market,

individuals with medium levels of student loan debt or with low income levels (and large levels of student loans) use credit card debt to reduce their default on student loans. On the one hand, participating in the credit card market pushes borrowers towards increased default on their student loans, while on the other hand, taking on credit card debt helps student loan borrowers smooth consumption and pay their student loan debt, in particular when their student loan debt burdens are large. At the same time, given the importance of student loan borrowing and default behavior in credit card loan pricing, individuals with high levels of credit card debt are mostly "good risk" borrowers, i.e. individuals with low levels of student loan debt. Overall, these three effects induce a hump-shaped profile of student loan default on credit card debt. Similarly, we find a hump-shaped profile of student loan default on income. Individuals with medium levels of income default the most on their student loan debt but not as frequently on their credit card debt.

Next, we use our theory to understand how the interaction between the two credit markets affects default behavior in recent normal times (2004-2007) and in the Great Recession. Specifically, we quantify how much of the recent increase in default rates for student loans is due to an increase in student loan debt and how much is explained by changes in the credit card market. We find that the expansion of both markets in normal times fully explains the increase in student loan default from 5 percent to 6.7 percent during 2004-2007, with 88 percent of the increase in default coming from the increase in student loan debt (by 20.7 percent) during this period. At the same time, a decline of 19 percent in income levels of young borrowers during the Great Recession accounts for a significant portion of the increase in student loan default (to 9 percent in 2010), whereas the changes in the credit card market have no effects on aggregate default rate. Specifically, while a lower risk-free rate (by 1.5 percent during 2007-2010) transfers risk from the credit card market to the student loan market and increases student loan default, a higher transaction cost during this period has the opposite effect. Overall, these two effects offset each other, resulting in a negligible combined effect on default incentives.

Lastly, we explore the policy implications of our model and study the impact of an income contingent repayment plan on student loans.6 We find that this plan completely eliminates the default risk in the credit card market and induces high levels of dischargeability of student loans. Overall, the policy induces an increase in welfare of 2.86 percent in a Great Recession environment but has a negative, although small, effect on welfare in normal times (0.14 percent).7 The elimination of risk in the Great Recession environment more than outweighs the welfare cost associated

6This plan assumes payments of 20 percent of discretionary income and loan forgiveness after 25 years. Details are presented in Section 4.4.

7The Great Recession environment in the paper supposes worse income outcomes, higher transaction costs in the credit card market and a lower risk-free rate in the economy.

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with high dischargeability and thus with high taxation in the economy. Results show important redistributional effects: poor borrowers with large levels of student loans benefit from the policy, while medium income borrowers with low and medium levels of debt are hurt by it. Medium earners are precisely the group who default the most under the standard repayment plan. Under income contingent repayment plans, these borrowers repay most of the student loan debt without discharging and also pay higher taxes to pay for bailing out delinquent borrowers. In contrast, poor borrowers with large levels of student loans are most likely to discharge their student loan debt under income contingent repayment plans, whereas in the absence of this repayment plan they are most likely to discharge their credit card debt. Our findings are particularly important in the current market conditions in which, due to a significant increase in college costs, students borrow more than ever in both the student loan and the credit card markets, and at the same time, they face worse job outcomes and more severe terms on their credit card accounts.

1.1 Related literature

Our paper is related to two strands of existing literature: credit card debt default and student loans default. The first strand includes important contributions by Athreya, Tam, and Young (2009), Chatterjee, Corbae, Nakajima, and Rios-Rull (2007), Chatterjee, Corbae, and Rios-Rull (2010), and Livshits, MacGee, and Tertilt (2007). The first two studies explicitly model a menu of credit levels and interest rates offered by credit suppliers with the focus on default under Chapter 7 within the credit card market. Chatterjee, Corbae, and Rios-Rull (2010) provide a theory that explores the importance of credit scores for consumer credit based on a limited information environment. Livshits, MacGee, and Tertilt (2007) quantitatively compare liquidation in the United States to reorganization in Germany in a life-cycle model with incomplete markets, earnings and expense uncertainty.

In the student loan literature, there are several papers closely related to the current study, including research by Ionescu (2010), Ionescu and Simpson (2010), and Lochner and Monge (2010). These papers incorporate the option to default on student loans when analyzing various government policies. Of these studies, the only one that accounts for the role of individual default risk in pricing loans is Ionescu and Simpson (2010), who recognize the importance of this risk in the context of the private student loan market. Their model, however, is silent with respect to the role of credit risk for credit cards or for the allocation of consumer credit because the study is restricted to the analysis of the student loan market. Ionescu (2010) models both dischargeability and non-dischargeability of loans, but only in the context of the student loan market. Furthermore, as in Livshits, MacGee, and Tertilt (2007), Ionescu (2010) studies various bankruptcy rules in distinct environments that mimic different periods in the student loan program (in Livshits, MacGee, and Tertilt (2007) in different countries) rather than modeling them as alternative insurance mechanisms available to

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borrowers. Our paper builds on this body of work and improves on the modeling of insurance options

available to borrowers with student loans and credit card debt. On a methodological level, our paper is related to Chatterjee, Corbae, Nakajima, and Rios-Rull (2007). As in their paper, we model a menu of prices for credit card loans based on the individual risk of default. In Chatterjee, Corbae, Nakajima, and Rios-Rull (2007), individual probabilities of default are linked to the size of the credit card loan. We take a step further in this direction and condition individual default probabilities not only on the size of the credit card loan, but also on the default status and the amount owed on student loans. All three components determine credit card loan pricing in our model. We argue that this is an important feature to account for in models of consumer default. Furthermore, we allow interest rates to respond to changes in default incentives induced by different bankruptcy arrangements in the two markets. To our knowledge, we are the first to embed such trade-offs into a quantitative dynamic theory of unsecured credit default. But capturing these trade-offs induced by multiple default decisions with different consequences poses obvious technical challenges. We provide mathematical tools to address these issues.

To this end, the novelty of our work consists in providing a theory about interactions between credit markets with different financial arrangements and their role in amplifying consumer default for student loans. Previous research analyzed these two markets separately, mainly focusing on credit card debt. Our paper attempts to bridge this gap. Our results are not specific to the interpretation for student loans and credit cards and speak to consumer default in any environments that feature differences in financial market arrangements and thus induce a trade-off in default incentives. In this respect our paper is related to Chatterjee, Corbae, and Rios-Rull (2008), who provide a theory of unsecured credit based on the interaction between unsecured credit and insurance markets. Also related to our paper is research by Mitman (2012), who develops a generalequilibrium model of housing and default to jointly analyze the effects of bankruptcy and foreclosure policies. However, our research is different from Mitman (2012) in several important ways: our paper focuses on the interplay between two types of unsecured credit that feature dischargeability and non-dischargeability of loans. In addition, we study how this interaction between two credit markets with different bankruptcy arrangements changes during normal times and during the Great Recession.8

The paper is organized as follows. In Section 2, we describe important facts about student loans and credit card terms. We develop the model in Section 3 and present the theoretical results in Section 4. We calibrate the economy to match important features of the markets for student

8In related empirical work, Edelberg (2006) studies the evolution of credit card and student loan markets and finds that there has been an increase in the cross-sectional variance of interest rates charged to consumers, which is largely due to movements in credit card loans: the premium spread for credit card loans more than doubled, but education loan and other consumer loan premiums are statistically unchanged.

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